Company Valuation Methods. the Most Common Errors in Valuations
Pablo Fernández. IESE Business School
Company valuation methods. The most common errors in valuations
Company valuation methods. The most common errors in valuations∗
Pablo Fernández PricewaterhouseCoopers Professor of Corporate Finance IESE Business School Camino del Cerro del Aguila 3. Telephone 34-91-357 08 09. 28023 Madrid, Spain e-mail: fernandezpa@iese.edu
In this paper, we describe the four main groups comprising the most widely used company valuation methods: balance sheet-based methods, income statement-based methods, mixed methods, and cash flow discounting-based methods. The methods that are conceptually “correct” are those based on cash flow discounting. We will briefly comment on other methods since -even though they are conceptually “incorrect”they continue to be used frequently. We also present a real-life example to illustrate the valuation of a company as the sum of the value of different businesses, which is usually called the break-up value. We finish the paper showing the most common errors in valuations: a list that contains the most common errors that the author has detected in the more than one thousand valuations he has had access to in his capacity as business consultant or teacher.
JEL Classification: G12, G31, M21 Keywords: Value, Price, Free cash flow, Equity cash flow, Capital cash flow, Book value, Market value, PER, Goodwill, Required return to equity, Working capital requirements
February 28, 2007
IESE Working Paper No 449 Previous updates: January 2002 and July 2004
∗
Another version of this paper may be found in chapter 2 of the author 's bookValuation Methods and Shareholder Value Creation, 2002 Academic Press, San Diego, CA.
1
Pablo Fernández. IESE Business School
Company valuation methods. The most common errors in valuations
For anyone involved in the field of corporate finance, understanding the mechanisms of company valuation is an indispensable requisite. This is not only because of the
Company valuation methods. The most common errors in valuations
Company valuation methods. The most common errors in valuations∗
Pablo Fernández PricewaterhouseCoopers Professor of Corporate Finance IESE Business School Camino del Cerro del Aguila 3. Telephone 34-91-357 08 09. 28023 Madrid, Spain e-mail: fernandezpa@iese.edu
In this paper, we describe the four main groups comprising the most widely used company valuation methods: balance sheet-based methods, income statement-based methods, mixed methods, and cash flow discounting-based methods. The methods that are conceptually “correct” are those based on cash flow discounting. We will briefly comment on other methods since -even though they are conceptually “incorrect”they continue to be used frequently. We also present a real-life example to illustrate the valuation of a company as the sum of the value of different businesses, which is usually called the break-up value. We finish the paper showing the most common errors in valuations: a list that contains the most common errors that the author has detected in the more than one thousand valuations he has had access to in his capacity as business consultant or teacher.
JEL Classification: G12, G31, M21 Keywords: Value, Price, Free cash flow, Equity cash flow, Capital cash flow, Book value, Market value, PER, Goodwill, Required return to equity, Working capital requirements
February 28, 2007
IESE Working Paper No 449 Previous updates: January 2002 and July 2004
∗
Another version of this paper may be found in chapter 2 of the author 's bookValuation Methods and Shareholder Value Creation, 2002 Academic Press, San Diego, CA.
1
Pablo Fernández. IESE Business School
Company valuation methods. The most common errors in valuations
For anyone involved in the field of corporate finance, understanding the mechanisms of company valuation is an indispensable requisite. This is not only because of the
References: Brealey, R.A. y S.C. Myers (2000), Principles of Corporate Finance, New York, McGraw-Hill, 6th edition. Copeland, T. E., T. Koller, y J. Murrin (2000), Valuation: Measuring and Managing the Value of Companies. 3rd edition. New York: Wiley. Copeland and Weston (1988), Financial Theory and Corporate Policy. Tercera Edición, Addison-Wesley, Reading, Massachusetts. Faus, Josep (1996), Finanzas operativas, Biblioteca IESE de Gestión de Empresas, Ediciones Folio. Fernandez, Pablo (2002), Valuation Methods and Shareholder Value Creation, Academic Press, San Diego, CA. Fernandez, Pablo (2001a), “Internet Valuations: The Case of Terra-Lycos”, SSRN Working Paper n. 265608 Fernandez, Pablo (2001b), “Valuation using multiples. How do analysts reach their conclusions?”, SSRN Working Paper n. 274972. Fernandez, Pablo (2001c), “Valuing real options: frequently made errors”, SSRN Working Paper n. 274855. Fernandez, Pablo (2004), “The Value of Tax Shields is NOT Equal to the Present Value of Tax Shields”, Journal of Financial Economics, (July). Vol. 73/1 pp. 145-165. Fernandez, Pablo (2004b), "Valuing Companies by Cash Flow Discounting: Ten Methods and Nine Theories", SSRN Working Paper n. 256987. Fernandez, Pablo and Jose Maria Carabias (2006), “96 Common and Uncommon Errors in Company Valuation”, SSRN Working Paper n. 895151. Miller, M.H. (1986), “Behavioral Rationality in Finance: The Case of Dividends”, Journal of Business nº 59, pp. 451-468 (october). Sorensen, E. H., and D.A. Williamson (1985), “Some evidence on the value of the dividend discount model”, Financial Analysts Journal 41, pp. 60-69. 27